Credit derivatives house of the year: Credit Suisse

David Goldenberg, Credit Suisse’s head of global index and options, and head of US credit derivatives, saw the warning signs last February. Some of the firm’s most astute clients were putting on curve-flatteners that would pay out if credit risk increased in the short-term. Others were buying credit default swap (CDS) options in anticipation of spreads widening in March.

After speaking with clients about their positioning, Goldenberg decided to take evasive action. First, he covered the desk’s short volatility positions. “We got out of steepeners,” he says. “We made sure we weren’t shorting any downside in options.” He also hedged a portfolio of short-dated bonds the desk had accumulated by purchasing put options on LQD, an exchange-traded fund that tracks US investment grade credit. Goldenberg says it was the best risk/reward he had ever seen on a trade.   

Within weeks, the US credit markets were in meltdown. The Covid-19 pandemic crippled corporate earnings and everyone wanted credit protection. CDS indexes jumped to their highest levels on record, according to Bloomberg data.

Credit Suisse was a step ahead of the tide. The moves it made in February paid off in a big way. The put options on LQD returned 30 times the initial premium outlay.

The desk was also actively sourcing front-end single-name CDS protection from issuers of synthetic collateralised debt obligations in the second half of 2019 and early 2020. 

All of this meant it was in a good position to offer liquidity when credit spreads blew out in March. “When volatility escalated, we were able to help clients with what they needed to do without needing to protect ourselves,” says Goldenberg.

The numbers bear this out. Analytics firm Coalition ranked Credit Suisse first for global credit derivatives trading revenues in the first half of 2020. Global credit derivatives revenues tripled compared with the same period in 2019. The US index business executed roughly twice as many trades as its closest competitor in the first half of 2020, according to an internal analysis of Bloomberg data.

The European business was no slouch, either. According to Coalition, Credit Suisse ranked first for client wallet market share for European high-yield single-name CDSs in the first half of 2020. Its market share in European investment-grade single-name CDSs has tripled since the start of 2019, according to a comparison of internal volumes with data available through the Depository Trust & Clearing Corporation’s swap data repository.       

The bank estimates that its market share in certain single-name CDSs, such as the travel company TUI and shipping firm CMA, was upwards of 40% in March and April.

We got out of steepeners. We made sure we weren’t shorting any downside in options

David Goldenberg, Credit Suisse

Clients also vouch for its stellar performance during the market stress in 2020.

“The days when indexes were moving around by 20 basis points at a time, it was very hard to get a firm price on single-name CDSs. They were always there pricing blocks, pricing things when it was volatile, sticking to levels,” says a credit derivatives trader on the buy side.

Credit Suisse’s US business was “always consistent”, says another buy-side client, adding: “They’ve established themselves as a central hub for larger sizes and liquidity.” 

A third buy-side credit derivatives trader says they were able to unwind in a single trade a nearly $100 million single-name CDS position in multiple expiries with Credit Suisse that other dealers would not have been able to price in size.

“Anything that has a thematic, interesting angle and trades wide, that’s where they stand out even more. Everybody can trade the strong BBs. The value add is really when you have an interesting situation — normally it’s 3 points wide, but they’re able to really minimise the bid/offer and put you in a position where you get the size or risk that you want at the right level. As an investor, those are the trades that are most value-added,” says the third trader.

Trusted traders

Led by Jonathan Moore and Daniel McCarthy, who serve as co-heads of global credit products, the bank has 60 front-office staff globally across sales, trading and strategy dedicated to CDS flow.

Basil Eggenschwyler, head of credit trading for Europe, the Middle East and Africa, says the credit derivatives team approached the market differently during the crisis. Instead of trying to cover everything, they found it more fruitful to focus on specific names that were of special interest to clients on any given day. Gapping prices also meant the indicative prices the desk periodically sends to clients quickly became out of date. To get trades done, the team had to spend more time negotiating on the phone and via electronic chats. “You completely change the way you interact with clients,” Eggenschwyler says about the crisis.

The bank’s prior efforts to build market share in distressed names also paid dividends. Clients already viewed Credit Suisse as a reliable source of block liquidity in difficult names and were reluctant to disclose their interest to competitors when the market became strained.

“Clients realise that opening up about a trade on a difficult name to a counterpart that doesn’t have the expertise – or doesn’t have the market depth we have – may end up costing them money because information was worth a lot more in March,” says Eggenschwyler.

As clients were generally reluctant to tip their hand in the crisis, non-competitive electronic trading worked well for index trades. “The screens enabled a lot of liquidity to pass through the market, and that was a bit of a virtuous cycle, in that it brought more players in and allowed more risk to clear,” says Goldenberg. “The index market as it is structured now gained a lot of credibility through the crisis because of that.”

While CDS options liquidity held up during the crisis, the contracts proved harder to trade in the following months. The bank’s capital-light model meant the desk had to rely on client relationships rather than balance sheet to provide liquidity. The trick was to offset the demand for credit hedges with profit-taking flows from the traditional hedging community.

“There were several waves of this as hedgers rolled their protection to higher and higher strikes as the market widened. It was our closeness with both sides of the market that allowed us to help our clients to collapse risk on the option side,” says Goldenberg.

Arbitrage opportunities

Some contingency planning was done months ahead of time via the structured credit desk, and with the help of private clients. Through Global Trading Solutions (GTS) – a joint venture connecting the private bank and investment bank – ultra-high net worth investors such as family offices provide a unique risk-sharing outlet for trading activities.

Since 2018, GTS clients bought $15 billion notional of index skew notes from CS, ultimately warehousing mark-to-market volatility on the popular credit arbitrage trades. In stress scenarios, CDS indexes tend to diverge from the fair value of the underlying single names – the so-called index skew – as indexes respond faster to macro factors due to their superior liquidity. Traders can monetise these dislocations through packages of index and single-name CDSs, yet the exposures can be expensive for banks to warehouse from a capital perspective.

By packaging the trades into a note format, the bank transfers the volatility associated with these positions to private clients, who are less mark-to-market sensitive and better able to warehouse the risk. Noteholders receive a 50bp-100bp pick-up over typical bank funding in return for weathering potentially wild moves, while CS makes a profit if skew exceeds the coupon paid.

The notes business is in some ways a self-reinforcing cycle. Credit Suisse’s dominant flow desk is able to create attractive skew packages for private clients, and this distribution channel brings additional orders and flow into the market-making book.

The trading opportunities did not end after volatility peaked in March. Basis trades exploiting the difference between cash and CDS markets continued to be lucrative in the following months.

In crisis scenarios, bond spreads tend to widen more than the comparable CDS spread for the same entity, as investors offload cash instruments to raise cash. They can monetise this dislocation via a negative basis package, which sees them buying a bond and offsetting CDS.

Popular with institutional investors, the trade was also packaged into negative basis notes for GTS clients, which once again proved an important risk-sharing outlet for volatility.

Another trade that performed well for CS in the second half of the year was a decompression trade, where it owned senior secured bonds hedged with CDS protection on unsecured debt. 

Clients also looked to trade the divergence between corporate names during an uneven economic recovery.

“This was really a real economy crisis, so the trading was quite different [than during the financial crisis in 2008]. We had a big correlated move to start with, but then that quickly gave way into a more nuanced move where you had winners and losers,” says Moore.

In September, a hedge fund client approached Credit Suisse to develop a long-short single-name CDS basket to trade the diverging paths of cyclical and non-cyclical European companies. The resulting portfolio developed by the sales, strategy and trading teams resulted in trades totalling €200 million in notional between the bank and hedge fund.